Advisor versus film: The Big Short (2015)

Experts: Alexander Dyck, a professor of finance and economics at the University of Toronto, and Benjamin Felix, an investment advisor at PWL Capital

Accuracy rating: 8.5/10


Nominated for five Academy Awards, and winner for Best Adapted Screenplay, The Big Short (2015) retells the events leading up to the financial crisis of 2008 while educating and entertaining the audience.

Based on Michael Lewis’ nonfiction book, The Big Short: Inside the Doomsday Machine, the film accessibly portrays the collapse of the housing market and the economic impact of financial instruments like collateralized debt obligations (CDOs). It’s humorous at times — such as when actress Margot Robbie explains shorting the market to the audience while in a bubble bath — and at other moments it’s heart wrenching, as we see millions of people losing their jobs and homes. While mostly renamed, the film’s characters are based on real-life traders and investors.

The film follows hedge fund manager Michael Burry (Christian Bale, whose performance is nominated for a Best Supporting Actor Oscar), who is the first to discover the extent of the housing market’s instability. When word gets around, Deutsche Bank trader Jared Vennett (Ryan Gosling) wants in on Burry’s strategy of profiting from the impending crisis. Soon, another hedge fund manager working under the Morgan Stanley umbrella, Mark Baum (Steve Carell) hears the news, and he too wants to participate — uncovering further market flaws in the process. Next, rookie investors Charlie Geller (John Magaro) and Jamie Shipley (Finn Wittrock) read about what’s happening, and enlist former banker Ben Rickert (Brad Pitt) to help them invest.

Through the movie, the main characters’ disdain for the financial system is clear. The institutional flaws that abetted the economic collapse are highlighted frequently, and Wall Street is illustrated as teeming with greed and self-importance.

So, was the film’s depiction of the finance industry and the 2008 crisis accurate? Hollywood thinks so — the film won an Oscar for Best Adapted Screenplay. But what do finance experts think? University of Toronto finance and economics professor Alexander Dyck and PWL Capital investment advisor Ben Felix say it’s accurate — for the most part.

Lack of luck

The Big Short focuses on a few characters who predict the collapse of the U.S. housing market. Though each discovers the bubble in a different way, all capitalize on that find by shorting CDOs — instruments filled with mortgage-backed securities — by using credit default swaps.

For instance, Burry saw that many mortgages supporting the securities inside CDOs weren’t investment-grade, as commonly thought, but were actually subprime. Subprime mortgages are for people who wouldn’t usually qualify for a traditional loan, such as those with poor credit. Burry invested US$1.3 billion of his fund’s capital into swaps, betting against the prospects of mortgage-backed securities, and saw a gain of more than 400% — which happened in real life.

“One of the first things that struck me was that these guys were portrayed as extremely intelligent,” Benjamin Felix says. “But at the same time they were in a lot of ways lucky to have identified this.”

Predicting the right time to make a move adds a second layer of luck. “Even if you’re right, it takes a lot of guts to maintain that position and wait for the market to turn,” says Alexander Dyck. “The longer it takes, [the] more things [that] can show up to change the circumstance. I think the movie portrayed that pretty well.” In the film, Burry’s investors pressure him to drop his swap strategy because they don’t believe the housing market will collapse. The more time passes, the more backlash he faces.

And in real life, says Dyck, fund managers may never trip upon a smoking gun like Burry and the other characters did. The movie exaggerates the probability of that happening. “You learn from this that you should go with your gut,” he says, “but if your gut is fundamentally different than a lot of other smart people, most of the time you’re going to be wrong.”

And in reality, a wider group of people predicted the end of the U.S. housing bubble.

What are these things?

Collateralized Debt Obligation: This product, as explained in the film through a cameo by chef Gordon Ramsay, is a group of securities that have been pooled together and then separated into tranches (sections) based on their risk levels. The securities — often bonds, loans and mortgages — are used as collateral. The CDOs discussed in the movie had tranches of mortgage-backed securities ranging in risk level from AAA (low risk of default) to BB (higher risk). The main characters discovered, however, that the mortgages backing those securities were at a much higher risk of default than their ratings suggested. Cue the financial crisis.
Credit Default Swap: When the main characters discovered how risky CDOs really were, they bought credit default swaps so they’d still get their money back if people couldn’t pay the mortgages underlying the CDOs. This type of swap transfers the risk associated with a security like a CDO from the buyer to the swap’s seller. The buyer pays premiums to the seller (like an insurance premium) until the swap reaches maturity. In return, the swap seller agrees to compensate the swap buyer if the CDO issuer defaults. In the film, once the housing market tanked and the CDOs followed suit, the main characters’ swaps pay off.
Subprime mortgage: People with low credit scores or low income generally have a difficult time taking out loans since they pose a greater risk to lenders. They may not qualify for conventional mortgages, so some institutions will lend to them at a higher interest rate than the prime lending rate. The characters in the film figure out the CDOs were filled with mortgage-backed securities made of subprime mortgages with high default rates — in other words, they were risky and unsustainable.

“There were a lot of people speculating there was a housing bubble,” Felix says. “But it’s one thing to know there’s a bubble and another thing to act on it in the way these guys did. They took massive risks and if they’d been wrong, they would have lost huge amounts of money.”

The U.S. government’s role

As the film progresses, the audience learns about the factors that led to the collapse of the housing market: the popularity of subprime mortgages, the ratings companies that hid the bad quality of mortgage-backed securities and CDOs, and the ignorance of people in powerful positions.

However, Dyck says there is a second theory about the cause of the financial collapse that the movie didn’t address adequately. Though flaws in the financial institutions exacerbated the problem, government regulations were at the root, he says.

“Government agencies [were] a major buyer of these mortgage-backed securities,” says Dyck, adding that the government encouraged banks to make home ownership possible for more people. In the years leading up to the crisis, the government also loosened the rules around investment banking, allowing the major banks to dramatically increase their trading activities in proportion to how much money they actually held.

“That dramatic increase in leverage certainly contributed to the crisis, and the government got influenced by major industry players.”

Faulty credit ratings

Since the film focuses on the weaknesses of the financial instruments associated with the housing market, mortgage-backed securities are depicted as corrupt. But, that’s not necessarily the case, says Dyck.

“The instrument isn’t the problem; it’s that it [was] vetted within a financial system with these huge [credit-rating] agency problems.”

After the characters discover that the housing market is backed by faulty mortgages, they find out that the major credit rating agencies are incorrectly assigning high ratings to the CDOs containing those junk mortgage-backed securities — making the investments seem safer than they are.

So, Baum meets with a representative from Standard and Poor’s to find out the motivation behind the false ratings. He learns the agencies gave good ratings to the CDO products, without checking them, to keep major banks’ business. In real life, ratings agencies say they did their homework when checking the CDO’s creditworthiness – which the real-life versions of Baum and Burry dispute.

In that system, Dyck says, mortgage-backed securities were destined for failure. “If you can reduce those agency problems, mortgage-backed securities are a perfectly reasonable thing to have,” he adds.

People were ignorant to financial flaws

Though the rating agencies, banks and other financial institutions contributed to the economic collapse, Felix says most people involved didn’t realize they had a part in the crisis.

“People think this was a big conspiracy to make a ton of money but I think it was a bunch of clueless people operating in silos,” he says. “There were a lot of people acting in their own best interests [who] didn’t have the knowledge or capacity to understand what they were doing was potentially causing some major structural issues.”

Felix says the the film’s best example of that ignorance were two mortgage brokers from Florida who almost exclusively sold adjustable-rate, subprime mortgages without anticipating the consequences if the market fell.

“They were completely clueless and playing into the problems, [and] they didn’t know that. The guys above them who were creating the mortgage-backed securities probably didn’t realize they were doing anything wrong, either.”

Dyck agrees there wasn’t a conspiracy because a lot of the people in the middle of the mortgage market — the brokers, the bankers and the managers — also suffered. “They didn’t know the bottom was going to fall out of the market, because if they knew that they wouldn’t have been involved themselves.”

What happens to the main characters at the end of the film is true to life (spoiler alert).

Each makes hundreds of millions of dollars through their short positions. And the effects of the financial crisis are well known: lost jobs, foreclosed homes, and little accountability. Only one banker went to jail: a Credit Suisse executive named Kareem Serageldin who lied about the losses of a CDO. No other major bankers or regulators were given jail time.

The verdict

Felix says he would rate the film 9/10 because “it was realistic from a financial perspective, and it was explained at a level that most people could understand.”

Dyck agrees that it explained complex financial instruments well, but gives it an 8/10. “It’s the omissions. They told one side of the story and they told it well through a couple of individuals.”

Still, he admits he laughed out loud in the theatre. “They have to be given some serious applause for taking important information and making it funny so you can actually learn something along the way.”